U.S.: The economic policy path going forward

*The most likely policy implication of the U.S. elections is President-elect Biden will be forced to work with a split-power Congress—either as a result of the Republican Party maintaining a thin majority in the Senate or by a 50-50 split in which Democrats would control because Vice President-elect Harris will preside over the Senate and would cast the deciding vote, but with several moderate Democrats that will lean against Biden’s progressive proposals—which is most likely to result in moderate fiscal policy changes, dramatically less than Biden’s strikingly large tax and spending increase proposals.

*Another fiscal package with more deficit spending is very possible, particularly in light of the dampening economic impacts of the second wave of the pandemic and scheduled expiration of unemployment compensation benefits. It is possible that fiscal legislation is passed by Congress and signed into law by year-end.  Any fiscal package would be significantly smaller than what Democratic leaders or Biden have proposed, but nevertheless would be sizable in a historic context and would boost the economic recovery. 

*While constrained on fiscal initiatives, the Biden Administration will be able to implement most of its expansive regulatory agenda independently of Congress through Executive Orders and various administrative rulings and interpretations by government agencies.  These will result in heavy regulations of labor markets that favor unions and lower-income workers, raising operating costs of businesses and punishing non-union employers, and will also focus on climate and environment-related activities, energy, banking, and the social media sectors. 

*The moderate increases in deficit spending and at most modest increases in taxes will support continued economic recovery and skew the mix of GDP toward consumption, housing and government, while the imposition of heavy regulations will generate production inefficiencies and reduce productivity and profits, and may dent business confidence.

*The Biden Administration will shift away from President Trump’s nationalism and anti-trade and anti-immigration international policies.  This will ease tensions and uncertainties and reduce disruptions to international trade.  Immigration regulations and Visas will be eased, which will provide favorable support to labor supply.  Diplomatic alliances with allies including Europe, Canada, and Japan will be re-established, and the U.S. will re-engage in international organizations including NATO, WTO, and WHO.

*The Biden Administration will maintain pressures on China through building a coalition of global allies and working through established channels rather than President Trump’s aggressively confrontational strategy.  Current tariffs are likely to be maintained, but threats of new tariffs as a policy lever will cease.

*Biden will be able to nominate many new Federal Reserve Governors to replace current Governors whose terms are scheduled to end, including Chair Powell and Vice Chairs Quarles and Clarida.  The new appointments will reinforce the Fed’s aggressive tilt toward dovish monetary policies and shift towards tighter regulations on big banks. 

The shifting political environment

The power of the President is immense on all fronts.  The President sets the policy agenda, directs the focus and the tone of the debate, and controls the vast Executive Branch bureaucracy that establishes important policies. Starkly the opposite of President Trump, who eschewed and purposely antagonized the establishment, but very much like President Obama, President Biden will embrace the establishment and the establishment will embrace him.  This will enhance the avenues for the executive branch to exert power and influence policies. 

Nevertheless, President Biden will be dealing with a split-power Congress in an extremely rancorous political environment. Senate election reruns in Georgia, where in the November 3 election no candidate met the state’s requirement that the winner must get 50% of the vote, will determine whether Republicans will maintain a slim majority in the Senate (Republicans need to win only one of the races to hold 51 seats) or there is a 50-50 split (this requires Democratic candidates win both races).  Currently, Republicans are favored to win at least one Georgia runoff. Although the races will likely be close, there is a lot at stake and polls are unreliable.

If the Republican Party maintains a simple majority, it would maintain control of the chair of every committee in the Senate, control the staffs, and determine the agenda.  As such, in a party-line vote, which is likely to be the tendency on fiscal issues, the Senate would be able to reject fiscal legislation initiated by the White House and passed by the House.  Senate majority leader McConnell has played that role in the current Congress.  With Biden proposing the biggest spending and tax increases in modern history, this is important.

If the Senate is split 50-50, Vice President-elect Kamala Harris becomes President of the Senate and casts the deciding vote, which swings control to the Democrats.  As such, Democrats would control every committee chair.  However, in that situation, things get complex, and the control is limited and not absolute.  Even before any legislation is proposed and votes are cast, the new Senate must iron out many procedures on basic operations, including committee assignments, staffing and budgeting, and voting procedures.  Democratic leader Senator Schumer and Republican leader Senator McConnell must negotiate on these issues.  In this situation, things may go smoothly, as it did following the highly contested Presidential election in 2001, when Republican and Democratic leaders worked together and enacted constructive legislation.  On the other hand, things may go badly.  Both Schumer and McConnell are under tremendous pressure, and not the best of friends.  Failure to cooperate would add to Congress’s already dysfunctional woes.  

Besides Biden’s victory, the poor showing of Democrats, and particularly the voters’ tilt against progressives (not just in the Congressional races, but also in most state government elections), dilutes the power of the Democratic Party and its leaders.  This will significantly reduce the probability of progressive legislation (fiscal and otherwise) and increase the power of moderates.  House leader Pelosi has lost power within the Democratic Party, as her strategy of pushing legislation through the House (in May) that proposed an additional $3 trillion in COVID-19 relief spending that was considered highly infeasible at the time, and overplaying her hand in subsequent negotiations that contributed to the failure of any legislation to pass, is perceived to have contributed to election losses of some incumbent House Democrats.  To a lesser extent, Senator Schumer’s power in the Party was also diluted. 

While the Democratic Party has shifted to the left, there is a clear divergence between moderates and progressives.  Leaders Pelosi and Schumer have clearly lost prestige within the Democratic Party and are being pushed by hard-left members. Several moderate Democratic Senators who in the past have crossed the political aisle and voted with Republicans on select issues are in a position to influence legislative agendas and outcomes.  In particular, Senator Manchin of West Virginia is a moderate on fiscal policy issues, and may side with Republicans on tax and spending legislation, which will force the Biden Administration to temper the legislation that it proposes.  Senator Manchin has already announced that he will block any efforts by Democrats to change the filibuster voting mechanisms or pack the Supreme Count.  

President-elect Biden’s nomination of Janet Yellen as Secretary of the Treasury adds credibility to his Administration.  She favors Biden’s expansive spending and tax proposals and progressive policies.  However, she is a seasoned veteran, understands that she will have to negotiate with a split-power Congress, and that the economic recovery has exceeded expectations since the House passed the Heroes Act in May, which involved an additional $3 trillion in deficit spending.  As such, she will support a much more modest initiative, much closer to Senator McConnell’s starting offer of $500 billion.  The actual policy outcome will depend critically on Congressional negotiations, and how much additional spending Senate Republicans would be willing to support.

Fiscal policy prospects

The diluted power of the Democratic Party, either under a Republican-controlled Senate or a 50-50 split that provides leverage to moderate Democrats, rules out Biden’s massive spending and tax proposals and other economic progressive policy initiatives, but it certainly does not rule out fiscal legislation. Toned down legislation for more spending on pandemic-related medical and health services and an extension of enhanced unemployment compensation and income support for small businesses seem likely.  Legislation providing a moderate amount of funds for infrastructure, climate change initiatives, and grants to states will receive serious consideration.

Off the table initiatives include the House’s $3 trillion Heroes Act, or even the $2 trillion proposal recently floated by Pelosi, along with Biden’s proposed $2 trillion new spending (in four years) for his New Green Deal and write-down of a chunk of student debt.  Most of Biden’s over-the-top, onerous tax increase proposals will also be scuttled, including a near doubling of taxes on capital gains, significant increased taxes on privately-owned businesses and corporate income earned overseas and payroll taxes of higher income workers.  As we have discussed earlier (US 2020 Presidential Election: Implications for Policies and Economic Performance, October 1, 2020), if fully implemented, Biden’s proposed tax increases would have harmed economic performance and reduced potential growth.  But even before the election, it was uncertain whether Biden would push ahead with his entire economic platform or tone it back.  Now it will definitely be trimmed.

The current political and economic realities and the intensification of the pandemic that has begun to slow the economic recovery (Real-time insights, economic and financial pulse, November 30, 2020) are likely to elicit a moderate spending package of sufficient size to materially lift the economy.  The government’s $3 trillion in income support to unemployed individuals and small businesses and grants to state and local governments provided by the CARES Act (13% of GDP) and related legislation were crucial in supporting the solid recovery and necessary medical support.  Relative to the magnitude of the economic contraction (10.1% in the first half of 2020 versus 3.9% during the 2008-2009 financial crisis), the CARES Act was modestly higher than the fiscal stimulus of $780 billion (4.9% of GDP) provided by the American Recovery and Reinvestment Act enacted in February 2009. A portion of the budget spending authorized by the CARES Act is still available to spend. 

The enhanced unemployment compensation provided by the CARES Act expired at the end of July.  Since then, solid economic improvement and healthy gains in employment contributed to lowering the unemployment rate to 6.9% in October from its peak of 14.7%.  However, unemployment is approximately 11 million, far above its pre-pandemic level, and the duration of unemployment is rising.

The renewed signs of weakness stemming from the second wave of the pandemic and select orders by state and local governments to curtail activities significantly raises the probability of fiscal action by Congress, particularly if unemployment rises.  The gap between McConnell’s offer of $500 billion in new spending and Pelosi’s prior offer of $2 trillion is narrowing significantly as Pelosi has indicated a willingness to negotiate from a $900 billion base.  McConnell may increase his most recent offer of $500 billion, and politically damaged Pelosi may be forced by Congressional Democrats to accept a much lower package.  It is possible that Congress and the Trump Administration agree to a package by year-end. 

Even at $500 billion, or 2.7% of GDP, a new fiscal package would be sizable.  It would include an extension of enhanced unemployment compensation and other forms of income support for unemployed individuals and small businesses, along with ample funds for medical provisions and health care services.  One contentious issue is Federal grants to states.  Democrats favor a very large amount—the Heroes Act included over $1 trillion—while Republicans are reticent because they believe that would be bailing out states for their fiscal mismanagement prior to the pandemic, particularly bailing out states for allowing out-of-control spending on public union pensions.  Is a compromise possible?  In light of the states’ financing gap generated by the pandemic and government shutdowns, independent of the states conduct of their finances, yes.  In Washington, it’s all about short-term politics.  And at this point in time, both leading Democrats and Republicans may perceive that they would benefit politically and in the public’s eye from a compromise.

Biden’s highest priorities

Even with trimmed prospects, the Biden Administration will continue to push its high priorities; while the split-power Congress will constrain the fiscal agenda, many of the initiatives will involve an expanded regulatory agenda. 

*Health care.  Addressing the needs of the pandemic is the top priority of the Biden Administration, followed by expanding coverage provided by the ACA.  There will be plentiful of funding for new government spending for pandemic-related medical supplies, vaccines, and follow-up health services.  A portion of the spending authorized by the CARES Act has not yet been spent by the Federal and state governments. If necessary, it is highly likely that supplemental legislation would provide more funding.

In addition, in response to some of the glaring constraints in global supply chains and perceived vulnerabilities of the U.S. health care system, some medical and health supplies and functions, including select pharmaceuticals, will be designated as critical to national security.  This will increase the government’s role in financing them and supervising their supplies, including some on-shoring of production or requiring production by companies in select “friendly allies”. Health care consumption and production, already a far larger share of GDP than any other advanced nation, will continue to rise. 

Congressional legislation for additional funding for expansion of the ACA, a priority of the Biden Administration, seems unlikely, but some expansion of coverage may be achieved largely through Executive Orders and administrative interpretations of laws.

Biden favors lower pharmaceutical costs, and similar to Trump, has proposed improved government negotiating between Medicare/Medicaid and pharmaceutical companies, and more improved access to cheaper foreign drugs.  The Biden Administration may also establish a review board for overseeing and supervising drug prices, but no details are available.  An excessive profits tax has been mentioned, but any speculation on such legislation is premature.

*Income support for the unemployed and disadvantaged and income redistribution.  There will be many initiatives aimed at income support and redistribution, but the magnitudes of new fiscal actions that Biden had proposed involving dramatic increases in taxes on higher-income individuals and corporations to be redistributed to lower-income households will be significantly trimmed, and largely blocked.

Besides fiscal initiatives, the Biden Administration will strive to raise wages and make workers better off through an array of labor regulations.  This will include minimum wages, worker protection and family leave initiatives, enhanced worker health care and improved pensions, occupational health and safety regulations, and a number of other measures. 

The Biden Administration will take aggressive steps to boost the role and power of labor unions and to force non-union workers to come under the control of unions.  Allocating government contracts exclusively to union employers, as Biden proposed in his election platform and punishing non-union firms, will receive highest priority.  Public teachers’ unions will receive full support, including constraints on charter schools (this has already been mentioned by Biden’s education team).  During his election campaign, Biden proposed outlawing right-to-work states (currently, there are 27), which if successful, would force non-union workers to pay union dues.

These regulation initiatives, aimed at raising wages of lower-income workers and raising the share of national income that is allocated to wages and salaries, would introduce distortions and inefficiencies in production processes and labor markets, which would reduce productivity and economic growth.  

*Climate change and green initiatives.  Biden’s proposed $2 trillion spending increase in four years for the New Green Deal will be sharply cut, but society and most business leaders strongly support initiatives that address climate and environmental concerns, so even without dramatic new spending, these policy issues will remain a key focus.  Trimmed down fiscal initiatives are likely, and significant regulatory changes are expected. 

Both sides of the political aisle favor infrastructure upgrading and increasing the reliance on renewable/sustainable energy.  A moderately sized fiscal package that addresses improving the electrical grid and power generation and storage, comprehensive high-speed internet access, research and development of renewable energy sources and uses, and basic transportation infrastructure is possible.  Debate about new fiscal initiatives will be contentious, which may improve any legislation enacted.

On the regulatory front, the Biden Administration will introduce many regulations and establish new standards that industry must address.  This will include standards on emissions control; constraints on coal and limitations on oil and shale and other sources of energy considered non-renewable (including banning drilling on Federal lands); goals for transition toward electric vehicles and reduced reliance on combustible engines; carbon content of imports; and many other activities. In anticipation of these regulations, many businesses have already shifted their strategies that would comply with these new regulations.

*Taxes:  getting high-income and better off individuals and corporations to pay more. Biden has proposed dramatically higher taxes, which if fully implemented would damage economic performance (US 2020 Presidential Election: Implications for Policies and Economic Performance, October 1, 2020).  Among the tax proposals that seemingly are off-the-table are dramatic increases in taxes on capital gains; payroll taxes of high-income earners; estates, and income earned by small businesses.  But, Congress may consider the merits of requiring corporations to pay higher minimum taxes on income earned overseas and assess some provisions of the corporate tax system that currently reduce corporate tax burdens. Republicans will strive to maintain the current tax structure that reflects the Trump tax cuts, but may agree to specific modifications, particularly if some modest tax increases are tied directly to spending on an infrastructure or green initiative.  However, to date, Republicans have rejected a carbon tax. 

*Foreign policy and tariffs.  Biden will dramatically shift the tone of diplomatic relations away from President Trump’s adversarial and combative approach to re-engaging in constructive diplomatic alliances with Europe, Canada, and Mexico, and other nations, and re-engaging in international organizations such as NATO, WTO, and WHO. This shift toward diplomatic relations with allies and ceasing threats of tariffs is expected to ease global tensions and uncertainties, facilitating the recovery in international trade and business confidence. 

The Biden Administration’s objective is to maintain pressure on China to open its markets to foreign goods and cease unfair practices involving the treatment of intellectual property and issues of international security, but its strategy will be decidedly different than Trump’s, involving:  1) building an international coalition of allies that pressures China on trade, issues of intellectual property, human rights and transparency, and relying more on established channels for grievances (WTO, etc.); and 2) maintaining current tariffs, but ceasing to use tariffs as a threat or policy lever.  Whether this approach successfully achieves its objectives is highly uncertain; no recent U.S strategies with China (President Clinton’s strategy of admitting China into the WTO, Presidents Bush and Obama strived to work through established diplomatic channels, and President Trump used tariffs and adversarial threats) were successful.

Many of these shifts in international policies can be achieved directly by the Biden Administration, independent of Congress.  Biden has proposed sizable cuts in defense spending, but those now seem highly unlikely with a split Congress.

*Immigration policy.  The Biden Administration will aggressively ease immigration policies, primarily through Executive Orders and rulings.  Visa quotas and requirements will be eased.  Border closings will be softened and the Administration will take steps to decriminalize undocumented immigrants.  Biden has proposed establishing a roadmap to citizenship of an estimated 11 million undocumented immigrants now residing in the U.S.  Such a significant change would require an act of Congress, which is a contentious issue. 

The easing of Visa requirements would be positive for labor supply, and would provide direct benefits for educational institutions and the high technology industries.  From an economic perspective, while foreigners illegally residing in the U.S. are already in the workforce, providing them citizenship would improve the mobility of labor supply and on the margin enhance longer-run growth. 

A note on regulations

The regulatory environment is important for various aspects of economic performance, confidence, and financial markets, but its impacts are often overlooked or overshadowed by the debate about fiscal and monetary policies.  One of President Trump’s initial policy thrusts in 2017 was to reduce burdensome regulations, and this was associated with a significant rise in business confidence and capital spending, well before any tax cuts were enacted (US: “soft” data and “hard” outcomes, March 9, 2017).  Anecdotal evidence suggests that regardless of the economic or social merits of specific regulations, businesses responded positively to a combination of changes in specific regulations and the general perception that the regulatory environment had become more “business friendly” than during the Obama Administration.  In many regards, businesses are more sensitive to how regulations affect their companies and industry than they do taxes.

Biden has proposed wide-sweeping changes in regulations.  Regardless of their economic or social merits, they will impact labor markets and specific industries, and their implications for business confidence and hiring require close attention.

Implications for the Fed

The Biden Administration will be able to fill many Governorships on the Board of Governors of the Federal Reserve System and has a significant influence on the conduct of monetary and banking policy.  Biden, like most Democrats, prefers easy money and low interest rates.  Currently, there are five standing Governors on the Board (including Chair Powell) and two vacancies.  At this point, the Senate is on track to confirm Chris Waller, one of President Trump’s nominees, but not Trump’s other nominee, Judy Shelton.  If so, that would allow Biden to nominate one new Governor when he assumes the presidency. 

The President’s nominees for Fed Governor must be confirmed by the Senate.  This includes undergoing hearings and majority vote approval in the Senate Banking Committee (SBC), and majority vote of approval in the entire Senate.  The process of nominating and confirming Fed Governors has become extremely political, with voting largely along party lines.  This is too bad, and is a dramatic change from history when nominees were assessed based on their merits.  Biden’s choice of nominees will be constrained if Republicans maintain control of the Senate, or maybe even if there is a split.  This rules out hard-left candidates and those who are on record favoring monetary and banking policies far outside the mainstream. 

The governorship of Randal Quarles runs until 2032, but his term as Fed Vice Chair for Bank Supervision—a position mandated by Dodd-Frank legislation in 2010, but not filled until Quarles assumed the position in 2017—expires October 2021, and in all likelihood, Biden will replace him.  Democrats argue that Quarles has eased regulations of big banks too much, and prefer tighter regulations.  At issue is getting a nominee for Vice Chair of Bank Supervision through the approval process.  The close split in the SBC as well as the whole Senate presents a potential obstacle.  The SBC includes moderate and right-wing Republicans who favor less regulations and moderate and hard-left Democrats, including Elizabeth Warren, who favor tight regulations and breaking up big banks.  With a close split in the Senate—and, unfortunately, many party-line votes—successful candidates must have many attractors and few defectors. 

Of note, in 2018 President Trump nominated Nellie Liang, the former head of stress-testing for the Fed and a seasoned veteran of bank regulation and risk management, to be a Fed Governor.  She faced strong opposition from bank lobbyists and dropped out of the confirmation process when it became apparent she did not have sufficient votes to be approved by the SBC.  Along with her, there are other candidates to replace Quarles with a background in bank supervision.  Two commonly mentioned as potential nominees are current Fed Governor Lael Brainard and former-Governor Sarah Bloom Raskin. 

In all likelihood, the replacement of Quarles as Vice Chair for Bank Supervision will result in policies that will shift toward tighter regulations of big banks.

Jay Powell’s term as Fed Governor runs until 2028, but his Chair expires in February 2022.  Biden may choose to replace Powell or re-nominate him.  Powell, a registered Republican, has widespread political support from both sides of the political aisle.  He was nominated to be Governor by President Obama in 2012 and nominated to be Chair by President Trump in 2018.  Although Powell has steered the Fed toward accommodative monetary policy, and aggressive ease during the pandemic, the Biden Administration must decide whether to re-nominate him or replace him with a party loyalist. Again, we emphasize that political considerations dominate just about everything in Washington.  If Biden replaces Powell, it will be with a nominee who will pursue a policy course that is at least as dovish as the Powell-led Fed.

However, there is a long history of Fed Chairs who have been re-nominated by presidents of the opposite political party and served long terms as Fed Chair.  In fact, these re-nominations have been more common than episodes when the President replaced the Fed Chair with a party loyalist:  William McChesney Martin was first nominated by President Eisenhower in 1951, served for five presidents through 1970; Volcker was first nominated by President Carter in 1979 and then by President Reagan; and Greenspan was first nominated by President Reagan in 1986 and served through the Clinton Administration and Bush Administration until 2005; and Bernanke, was nominated by President Bush and re-nominated by President Obama.

Rich Clarida’s term as Fed Board member expires in January 2022 and his term as Vice Chair expires in September 2022.  In all likelihood, Biden will replace Clarida, the Fed’s leading macroeconomist in the Fed’s monetary policy deliberations and the director of its significant longer-run strategic review.  Clarida emphasizes rigorous macroeconomic analysis and has a detailed understanding of financial markets.  Clarida has played a critical role in advising Chair Powell, who is trained as a lawyer, and guided monetary policy deliberations.  His departure will likely involve a material shift in the Fed’s deliberations.

Biden’s choice of Janet Yellen, former Fed Chair, as Secretary of the Treasury, will tilt the Fed toward accommodating the Treasury’s needs as the economy continues to recover, and as the Fed pursues a strategy for exiting from its emergency policies.  The Fed is an independent central bank, but its activities have been intertwined with the Treasury on many dimensions.  Its massive QE, enlarged balance sheet, and ultra-low interest rates constrain the government’s debt service costs, and it remits its substantial net profits earned from the positive carry on its assets to the Treasury.  The Fed’s new strategic framework, which favors maximum inclusive employment and higher inflation, is closely aligned with the Administration’s macroeconomic objectives.  Similar to Yellen, the Fed continues to view higher wages as integral to higher inflation.  The Fed’s purchases of corporate and municipal bonds, and its direct lending to businesses, involve credit and fiscal policies that are normally activities conducted by the Treasury.  Moreover, the Secretary of the Treasury and Chair of the Fed are responsible for overseeing and maintaining financial security. 

Thus, at least until the economy fully recovers and the Fed has begun to normalize its monetary policy—or until inflation rises uncomfortably—the Fed will conduct policy with an eye to the needs of the Treasury and Administration.

Mickey Levy, mickey.levy@berenberg-us.com